Explanation:
A is correct. Credit derivatives (e.g., CDS) were formulated precisely to enable this fine tuning. Credit derivatives are off-balance sheet instruments that facilitate the transfer of credit risk between two counterparties (the beneficiary who sells the risk and the guarantor who buys the risk) without having to sell the given position. Credit derivatives permit the isolation of credit risk (e.g., in a loan or a bond) and transfer that risk without incurring any funding or client management issues.
B is incorrect. Securitization involves the repackaging of loans and other assets into new securities that then can be sold in the securities markets. Banks, for example, have used securitization to remove mortgage loans, corporate bank loans, credit card receivables, and automobile loans from their balance sheets. The securitization of these assets resulted in the creation of mortgage-backed securities, collateralized loan obligations, credit card-backed securities, and automobile-backed securities, respectively. The latter two securitized products are referred to as asset-backed securities (ABS).
C is incorrect. Section 15G of the SEC Act of 2014 imposed risk retention provisions on asset-backed securities, including collateralized loan obligations (CLOs), of at least 5% of the credit risk. The Securities and Exchange Commission, in conjunction with U.S. federal banking regulators, finalized Section 15G of the Securities and Exchange Act in 2014. This imposed risk retention provisions on asset-backed securities, including CLOs. Specifically, the rules require securitizers to retain, without recourse to risk transfer or mitigation, at least 5% of the credit risk.
D is incorrect. Credit derivatives markets are actually effective in measuring default risk in real time (through CDS spreads that reflect current market views on credit risk), but this effectiveness diminishes over longer time horizons. The markets provide timely pricing of credit risk based on current information, not effective long-term measurement.
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Q-44. A credit manager at a US-based bank is preparing a presentation to a group of interns on the role of credit derivatives in the 2007-2009 financial crisis and on subsequent changes in the credit derivative markets. The manager describes some characteristics of credit derivatives and also discusses some regulatory changes unique to the credit derivative markets. Which of the following statements is correct regarding credit derivatives?
A
Credit derivatives can facilitate the transfer of credit risk without incurring significant funding liquidity risk.
B
Securitization is used primarily for repackaging corporate bank loans and is limited in its use for collateralized loan obligations.
C
The required retention of credit risk for originators of asset-backed portfolios was increased from 10% to 25% by the US Securities and Exchange Commission after the crisis.
D
Credit derivatives markets are effective in measuring default risk over longer time horizons but are ineffective in measuring default risk in real time.